Generally, a recession means a significant slowdown in industrial and trade activity. Which in turn leads to an uptick in unemployment, a downturn in real estate values, lower investment values and economic activity, a falling stock market, and eventually a dip in interest rates. All of which can seriously impact your wealth-building progress.
Economic research shows that inflation recently peaked at a 40-year high, the Federal Reserve has been raising interest rates faster than it has in 40 years and investors are seriously worried that 2022-23 will herald the beginning of the second great depression.
But, if you’re well prepared for the worst to happen, you can plan to mitigate the effect on your finances if a recession hits.
How to Prepare Your Finances for a Recession
Smart moves ahead of a recession involve following the Boy Scout code and always being prepared!
There’s no doubt that recessions can have a serious negative effect on your stocks and property portfolios, but if you’re ahead of the curve in preparing for a financial downturn, you could turn the situation to your advantage.
Mitigating the Damage to Your Personal Finances
A recession won’t only damage the economy, but it’s also likely to have a major impact on your personal finances because of changes in interest rates and precarious job security. This is why we recommend taking the following steps to ensure that your financial plans aren’t derailed by potential interest rate drops.
So here’s how you can build a financial backup plan to help prepare for a recession.
Budgeting to Build Your Wealth
Even in times of economic growth, living within your means is the best way to grow your wealth. And that means making sure that monthly expenses such as rent or mortgage payments, car payments, and discretionary spending stay within budget so that you’re feeding your savings accounts rather than servicing debt payments with any extra money, not taking on more debt.
So, to prepare for a recession in an economic downturn, you should be very mindful of staying within your budget. If you’re serious about creating a financial future that enables you to create generational wealth or boost your retirement account, you need to start by being intentional about how you spend money.
Keep Your Good Credit
Hold off making a down payment on big-ticket items, a new car payment, or even any extra payments on low-interest debts before thoroughly planning your strategy for recession. As you intentionally don’t take on new debt, pay down high-interest debt, and bolster your savings accounts, keep an eye on your credit score.
Now is a good time to get any blemishes cleared up with the credit bureaus so that your excellent track record can support you if need be. Remember, credit is a tool to be used wisely. If you find yourself in the position of needing a credit line at any point in the future, take intentional credit-boosting actions now so that your credit can support you when you need it to.
Start by pulling your credit report, not just for your score but so that you can confirm the creditors, balances, and activity listed. Good credit doesn’t just magically happen. Typically, it’s built intentionally over a sustained period.
Your clever financial decisions should help you widen the gap between income and expenses so that you can invest in the things that help you save for the future and achieve your investment goals.
Build an Emergency Savings Fund
To recession-proof your finances, you really need to prioritize building an emergency fund.
Your emergency safety net can:
- Save you needless stress.
- Help you avoid becoming financially over-extended.
- Ensure you don’t have to leverage debt just to get by.
Step one is putting aside 3 to 6 months of your basic living expenses to mitigate the risk of unemployment. Then you can continue the process by slowly boosting your emergency fund to a year of basic living expenses.
When you’re calculating your essential expenses, remember to add in everything you need to get by in your normal daily life – groceries, housing, utilities, and transportation – and build that emergency fund in a separate account so you’re not tempted to dip into it for other things.
Where Should You Put Your Emergency Fund?
Then you need to figure out where to keep your savings. Banks are currently raising savings yields quickly in response to the Fed’s aggressive rate hikes, which can make that a more attractive option than usual. But don’t forget that even these higher bank savings yields are well below the inflation rate, so money in the bank will still be losing purchasing power.
There may be options such as a debt fund that provide better yields and are still fairly liquid (unlike typical syndications). If you had to dig into your emergency fund, it’s unlikely you’d need the entire amount at once. So it may make sense to evaluate how much you need immediately liquid and how much you could wait 60 to 120 days to get access to and allocate your funds accordingly. It’s important not to sacrifice liquidity for yield.
In a recession, you don’t want to lock your cash up too tightly, but rather ensure that it remains accessible in case you need it because of job loss to cover expenses.
It’s critical to build up an emergency fund while your financial situation is stable, or the time may come when you have to start making difficult decisions about withdrawing money from your retirement account or applying for a home equity line of credit (HELOC).
Diversify Investments in an Economic Downturn
When the going gets tough, having a diversified investment portfolio is crucial. So, one of the most important things to do ahead of an economic recession is to ensure that your investments are evenly spread and your cash isn’t all tied up in one place. Spread your investments across multiple holdings to ensure that a dip in values in one area of your portfolio doesn’t negatively impact the overall value.
Look for long-term, stable assets with as little volatility as possible. Many investors already have company 401k’s, separate brokerage accounts, real estate, and even business investments. We’ve found the most stable, recession-resistant options to be in commercial real estate syndications like multifamily apartment complexes.
Many investors panic that a financial downturn also means falling stock prices — and that can be true, but don’t make significant changes to your investment strategy as a knee-jerk reaction.
Remember that markets tend to be forward-looking. We might be preparing for the recession now, but most investors are looking ahead and planning for when the times get better.
Pay Off High-Interest Debt
With a possible recession snapping at your heels, the last thing you need is a stack of high-interest debt to pay off. If you can pay off any debt you currently have, you can potentially save money in interest payments. Then you can put the extra into boosting your emergency fund.
Request a copy of your credit report to ensure that you don’t have any nasty surprises when it comes to paying off those debts.
We would always advise paying off any credit card debt BEFORE you plan any further investments, particularly because if you have high-interest debt, the cost of your interest payments may exceed the return on your investment.
Keep an Eye on Interest Rates
If you have a loan or credit card debt with a 20% interest rate, for example, it’s far better to prioritize paying off that debt over putting more into investments, as the average long-term rate of return in the stock market is likely to be considerably lower than that. Create a debt payoff plan to ensure that you’re paying off more than the minimum payment on your personal loan or credit card.
If you’ve been wanting to refinance any larger assets to lower payments or secure lower rates or better terms, now is the time. Banks typically tighten policies during tough economic times, making it even harder for consumers to get on their feet.
So, as you review your car, home, credit, and loan statements this month, take special notice of your balances and interest rates. Sometimes a simple call to the creditor can create savings for you. Other times, you discover that refinancing isn’t a bad idea.
Preparing for a recession is by no means impossible. There may be tough times ahead, but it makes sense to take proactive steps to get prepared and ensure that turbulent times don’t derail your financial goals.
Simply being aware of your numbers is a huge step. Gather all your statements, your credit report, and any other resources you use to track your finances. Then, take the time – a dedicated “money date” to sort through all of your accounts.
Feel free to create a spreadsheet or enter everything in an online tracker if that makes your heart happy. Either way, from an informed position, you can track your progress, create a game plan, and make changes to your strategy as needed.
Further reading: What Happens to Real Estate in a Recession and When You Should Buy